- 10 Marks
FM – L2 – Q57 – DCF: Taxation and Inflation
Question
CVB Ltd is considering whether to invest in new equipment costing GH¢600,000. The equipment is expected to have an economic life of five years and will have no disposal value at the end of Year 5 (and no disposal costs).
CVB’s after-tax cost of capital is 15%. Tax is charged at an annual rate of 35% and is payable in the year following the year in which the taxable profits arise.
The following forecasts relate to the project under consideration:
| Year | GH¢000 | ||||
|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | 5 | |
| Sales income | 250 | 250 | 300 | 350 | 400 |
| Direct materials | 50 | 55 | 58 | 64 | 70 |
| Direct labour | 25 | 25 | 30 | 30 | 35 |
| Total direct costs | 75 | 75 | 88 | 94 | 105 |
| Depreciation | 120 | 120 | 120 | 120 | 120 |
There will be tax allowances on the cost of the equipment, calculated at 25% each year on the reducing balance basis. The first depreciation tax allowance (capital allowance) would be claimed in year 0 (or very early in year 1).
Assume that:
(1) taxable profits are defined as income minus direct costs and capital allowances
(2) cash profits in each year = sales minus direct costs
Required
Calculate the net present value of the project and recommend whether or not the project should be undertaken.
Answer
Tax allowances on the investment
| Year of claim | Tax saving (35% of allowance) | Cash flow year | |
|---|---|---|---|
| Cost | GH¢600,000 | ||
| 0 | Allowance (25%) | (150,000) | 1 |
| 450,000 | |||
| 1 | Allowance (25%) | (112,500) | 2 |
| 337,500 | |||
| 2 | Allowance (25%) | (84,375) | 3 |
| 253,125 | |||
| 3 | Allowance (25%) | (63,281) | 4 |
| 189,844 | |||
| 4 | Allowance (25%) | (47,461) | 5 |
| 142,383 | どこ | ||
| 5 | Disposal | 0 | 6 |
| 142,383 |
Note: It is assumed that the company has taxable profits against which it can claim an allowance in Year 0 (or early in Year 1).
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
|---|---|---|---|---|---|---|---|
| GH¢000 | GH¢000 | GH¢000 | GH¢000 | GH¢000 | GH¢000 | GH¢000 | |
| Sales | 250 | 250 | 300 | 350 | 400 | ||
| Materials | (50) | (55) | (58) | (64) | (70) | ||
| Labour | (25) | (25) | (30) | (30) | (35) | ||
| Cash profits | 175 | 170 | 212 | 256 | 295 | ||
| Tax at 35% | (61) | (60) | (74) | (90) | (103) | ||
| Capital equipment | 600 | ||||||
| Cash effect of allowances | 53 | 39 | 30 | 22 | 17 | 50 | |
| Net cash flow | (600) | 228 | 148 | 182 | 204 | 222 | (53) |
| DCF at 15% | 1.000 | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 | 0.432 |
| PV of cash flow | (600) | 198 | 112 | 120 | 117 | 110 | (23) |
The project is just worthwhile, because the NPV is + GH¢34,000. However, the NPV is quite small in relation to the size of the capital investment, and in view of the fact that it is a five-year project.
It might be appropriate to carry out some risk and uncertainty analysis on the project, before deciding whether or not to undertake it.
- Topic: DCF: Taxation and Inflation
- Uploader: Samuel Duah